In 1993, Dennis H. Reilly at DuPont, advised that the global overcapacity for titanium dioxide was so massive and prices so low, he predicted producers would continue to underinvest in the business creating shortages when demand increased. Returns on capital in mining and production were low for two decades and operating at a loss was not unusual for some of the big TiO2 producers. The cycle is analogous to natural gas but perhaps even more exaggerated. Natural gas at $2 to $3 is a losing business and yet it takes time for E&P to cut production and rein in overproduction. TiO2 is similar and more unpredictable with cycles that are almost nonsensical.

Where normal business cycles often promote healthy competition, the cycles in titanium dioxide tend to be destructive to both producers and the industries that depend on titanium dioxide as a raw material. Mr. Reilly went on to remark that the industry was so dysfunctional that coordinated action among the suppliers was needed to correct it. It differs from natural gas – there are 5 or 6 TiO2 producers that account for 70% of titanium dioxide supplies and Dupont is around 40% of that. Competition is broader and spread across dozens of companies in natural gas.

After a decade or so of hardship and low prices in the 1990’s, antitrust litigation was brought against DuPont, Kronos, Millenium, Huntsman, and Tronox for price fixing. In a desperate attempt to bring prices up, they agreed to work together albeit illegally and began to co-ordinate price increases. Beginning in the early 1990’s TiO2 prices were unprofitably low, improved by the late 1990’s only to fall again in 2001. The suit alleged that prices were fixed in response to the 2001 crash. Increases started shortly after a series of industry meetings in 2001-2002. The rate hikes were initiated by DuPont and quickly followed by the other producers in unison. In spite of the apparent collusion, by 2008, the industry was again experiencing low to no profits and high raw material and energy costs resulting in a huge inventory overhang that was further exacerbated by the global financial crisis. TiO2 producers hit rock bottom in 2008. The industry responded by cutting inventories and shutting in capacity, making it difficult to re-start the supply chain when the market recovered. Supplies became tight by 2010 and paint was in such short supply even road maintenance had to be put on hold with no paint for centerline stripes.

With tight supplies, the TiO2 producers began a series of price increases in 2010 through 2011-- 8% in 2010 and almost 40% in 2011 -- 2011 was the best year the industry had in a couple of decades. End users began to build inventory and the record profits of 2011 were followed by a slow 2012 as paint companies held more inventory than they were using and began destocking. Prices fell and volume dried up.

Cycles are complicated by lagging response to increased demand. There is always a precipitous balance between oversupply with unprofitable pricing and undersupply/high prices with inventory hoarding. TiO2 production can’t be started fast after shutting down plants and mining operations, creating a business disrupting lag.

New mining operations take on average about six to eight years to enter the supply chain and production facilities are expensive to start up at around $450 million keeping barriers to entry high and production in the hands of the few. There will be no new TiO2 pigment plants built outside China before 2013 to 2014. That leaves the industry open to big cyclical swings over the next few years.

In 2008-2009 demand declined 9% -- a rare event. Growth is normally steady and slow and rarely hits negative numbers. Conventional wisdom says that it follows the rate of GDP. TiO2 producers permanently shut down 7% of global capacity in response to 2008 effectively ensuring short supply during recovery, no extra capacity to absorb demand and high prices. Expectations were high for a brisk 2012 but that ground to a halt in Q3 taking many in the industry by surprise. It’s a difficult industry to predict and cycles are complex.

That brings us to Tronox

Tronox wins the title of messiest company to evaluate—ever. It’s an unappealing story at present but may turn in to a beautiful business at some point. It got a favorable write-up in September 2012at the Value Investors Club with a share price of $26. The VIC thesis was TROX was undervalued on a free cash flow yield basis and its low share price was the result of destocking of TiO2 by customers and the bottoming out of the cycle. The analyst was in favor of stock repurchases at the undervalued share prices. Tronox bought shares at high September prices that went on to lose 38% of their value two months later. Management must have known by September that Q3 was going to disappoint the market but did the buybacks at high prices anyway. During the second and third quarters of 2012, they repurchased approximately 12.6 million Class A Shares -- 10% of the total voting securities at a cost of $326 million. Tronox management gets a demerit right from the start for the ill-timed, questionable stock repurchases.

Tronox Incorporated was spun off from Kerr-McGee in 2006 along with a high debt load and a lot of legacy environmental liabilities. In 2009, they declared bankruptcy, unable to pay debt and environmental obligations and emerged from the BK in February 2011 sans debt and environmental expenses. After being a pink sheet stock for more than 12 months, they were listed on the NYSE in June 2012 as Tronox Limited.

In September 2011, Tronox offered shares and cash for part of South African mineral sands miner Exxaro. In June 2012, the companies consolidated and listed on the NYSE. Tronox shareholders received $12.50 and one class A share. At the same time, Exxaro shareholders got Class B shares for partial interest. Exxaro retained 26% of the South African and sold its 50% in the Australian joint venture in Triwest to Tronox that now owns 100%.

There were 63.5 million class A shares and 49.8 Class B shares that underwent a 5 for 1 share split at the end of June 2012. That further complicates looking at charts and documents that do not reflect the split. Year-over-year comps become more difficult. There are also predecessor/successor adjustments, proforma results, split-adjusted results and a switch from a January year-end to December.

The business

Tronox is based in Western Australia. The titanium dioxide it refines is critical to coatings, plastics, and paper and most importantly paint. Tronox now has its own mineral sands mining business consisting primarily of two product streams—titanium feedstock and zircon. Titanium feedstock is used to manufacture TiO2. Zircon is used for the manufacture of ceramics, refractories, TV glass and a range of other industrial and chemical products. The combined company has global operations in North America, Europe, South Africa and the Asia-Pacific region. They operate three TiO2 facilities -- Mississippi, The Netherlands, and Western Australia, representing approximately 465,000 tonnes of annual TiO2 production capacity.

The Australian and South African mines can produce approximately 723,000 tonnes of titanium feedstock and approximately 265,000 tonnes of zircon. The company is able to supply their own feedstock and sell to third parties.

Tronox is the third largest producer of TiO2 from chloride technology; the second largest producer of titanium feedstock; the second largest global producer of zircon.

Supply and Demand

Historically, the majority of their revenue has come from the sale of TiO2 (86% and 93% in the three and nine months ended September 30, 2011). With the Exxaro mineral sands acquisition, revenue has become more diversified and TiO2 sales decreased to 57% (3 mos) and 73% (9 mos) of total revenue.

After a banner 2011, TiO2 sales are slowing in 2012 due to continued customer destocking and declining demand, primarily as a result of weaker residential and commercial construction in Europe and Asia.

While TiO2 has no substitute there are threats to its historically reliable increasing demand in the paint industry. Since paint/pigments make up 77% of TiO2 sales, any decreased end product use is going to negatively impact growth over the long-term. Dow chemicals brought its polymer Evoque to market in 2011 and will begin heavy promotion in 2012-2013. Evoque is a polymer that efficiently disperses TiO2 in paint so less TiO2 can be used for equal hiding capacity. Evoque polymers surround and attach to the surface of TiO2 particles. As the two materials come together, they form a composite that makes TiO2 better dispersed and more resistant to crowding. Dow believes up to a 20% reduction in titanium dioxide will be possible, while maintaining the paints ability to cover and hide the original surface.

Dow also makes Ropaque (introduced 30 years ago) and combining Ropaque with Evoque can decrease TiO2 by up to 50% and still keep paint’s ability to hide and cover equal to or better than the pure TiO2 containing product. PPG has already targeted a 4% decrease in TiO2 use discussed in the Q3 conference call. Sherwin Williams also mentions decreasing concentrations of TiO2 in paint.

The vertical integration of feedstock and TiO2 gives Tronox a secure low cost source of raw materials. The ability to balance production with feedstock supplies at predictable pricing will give them the opportunity to expand and stabilize margins. That may be the single best catalyst for an investment thesis. Margins in Q3 contracted with low utilization and a return to excess capacity. Gross and operating margins are not likely to improve over the next few quarters—traditionally the slowest in the industry. They should recover when macro issues improve and during peak demand quarters, boosting earnings in excess of revenue growth. At the earliest that would be Q2 and Q3 of 2013.

Historical data

Tronox emerged from bankruptcy in February 2011 and provides financial results back to 2008 but are unable give any further data claiming it is too costly to provide it per an SEC ruling. The financial documents they do provide are complicated by various one-time charges for the reorganization and the acquisition, proforma and successor/predecessor differences and a switch from their January to December year-end. What can be consistently tracked is the disastrous 2008 and recovery in 2011 before the acquisition. This is the pure titanium dioxide business. The high growth and expansive margins were short-lived and by the third quarter of 2012, Tronox was back to negative growth and negative margins. This decline was across the sector and seems to have taken Tronox, DuPont and Kronos all by surprise. Tronox shares dropped 21% and Dupont was down 10% after disappointing Q3 earnings.

Gross margins improved more than 3-fold from 2008 to 2011 and the company went from operating at a loss to operating margins of 19.5%. The high cost of sales in 2008 are responsible for the worst gross margins and biggest net losses in 4 years. Cash flow from operations was negative in both 2008 and 2009, recovering to $250 million in 2011.

Exxaro does not appear in the consolidated results until June 15 2012. It adds two weeks of revenue to Q2 and is present for all of Q3 2012.

In 2009, operating income went from negative operating earnings to over $67 million accounting for the outsized increase of 49-fold. Tronox continued to post positive growth numbers up through 2011 as volume, pricing and margins improved. Business was good through the first quarter of 2012, but by Q3, was back to low margins and no growth.

June 2012 is slightly distorted by two weeks of Exxaro revenue. That revenue was left in as cost of sales could not be be adjusted to account for Exxaro. The June quarter was also saw a tax benefit, altering net income and increasing net margin and net growth. In tow out of four years, the company has had tax benefits and has NOLs going forward that may be used. I left it in. Growth and margins were in an accelerating decline by the second quarter.

By Q3, gross margins were worse than the annual 2008 figure and disappointing since supplying their own feedstock should relieve some of the pressure on gross margins. Their margins should show highly competitive improvement over industry peers as the cycle moves up again. Unfortunately, anticipating upturns in the TiO2 cycles is not easy.

Third quarter 2012

What happened in Q3 to derail an apparent recovery in the TiO2 sector?

Pigment sales decreased by 30% as destocking by end users continued far beyond company predictions for destocking and the move into restocking. Exxaro revenue in Q3 was $207.1 million of the $487.3 million in total revenue for the quarter. The legacy business sales were $280 million and significantly worse than the Q3 2011 revenue of $465. The growth was only possible with the acquisition. Total revenue increased 5%.

TiO2 sales made up 57% of Q3 revenue compared to 86% one year ago. The diversification obviously improved sales. During 2012, both the minerals and pigment businesses are seeing declining volumes on market weakness in China, Europe, and North America. This may never correct in China as China is expected to be able to supply almost all of its TiO2 from internal sources. China may still need to buy feedstock. Europe and North America will not provide much of a market until the GDPs of both return to higher growth.

One of the more troubling developments is the increased cost of goods sold -- + 44% on 5% revenue growth. The increases reflect the higher pigment production costs, higher expense for raw materials and chemical products, and higher per unit costs due to lower capacity. I might have expected the vertical integration of their own feedstocks would help offset the effects of low utilization. Instead, raw materials cost increased rather substantially. Part of the increased cost of sales was $85 million in step up charges for Exxaro inventory. Backing that out gives a gross margin of 21%--still below Q3 2011 levels(28.1%). Operating margins adjusted to 9.6% from (7.8%). Operating margins Q3 2011 were 21%.

During 2012, they cut pigment production volume in response to decreased sales from ongoing customer destocking and global economic concerns. Reduced capacity utilization increased the cost per unit and negatively impacted margins.

Gross for the third quarter and the nine months declined due to lower sales volumes of TiO2 and zircon, and third party purchases of ore. Gross margin declined due to higher input costs for TiO2 but adding back the step up charge for Exxaro inventory improves it from 4% to 21%.

DuPont as the largest TiO2 producer is a good indication of how the sector is affected. They fell short of analysts’ expectations and are responding quickly by cutting 1,500 jobs in an effort to offset underutilization. DuPont reported net income of $10 million (1¢ per share earnings) compared with $452 million, or 48¢ per share Q3 2011. Excluding one-time items, earnings were 44¢ compared to 69¢ in 2011. Revenue from continuing operations totaled about $7.4 billion, down 9% from $8.1 billion. Share dropped nearly 10% in response. The CEO cited weak demand resulting in a return to overcapacity much the same as Tronox reported. The sector was hoping that market demand was going to continue to absorb capacity and support price increases. From record sales and volumes in Q3 2011, Dupont saw an 18% decline in volume and 19% drop in sales in 2012. The recovery of 2011 is not sustainable and end users are still in the process of winding down overstock. Tronox is predicting slow sales through the first half of 2013.

Cash flow, debt, share repurchases and dividend

Free cash flow for the first nine months of 2012 is ($23) million with $68 million in cash flow from operations (CFFO) and $91 million spent on capex. There was no free cash to pay the $31 million in dividends and issuing debt helped finance the dividends and the share repurchases.

Two one-time items occurring in January 2011 complicate the 2011 cash flow. Backed out, cash flow from operations for 2011 is approximately $250 million. That would not include any Exxaro numbers. Free cash flow for 2011 is around $110 million and an improvement over 2008-2010. That has not held into 2012.

Cash flow from operations for the first nine months (includes Exxaro for 3 1/2 months) is only $68 million. With the short history of the merger, it’s not possible to anticipate normal cash flow levels for the combined companies. Tronox Limited is not insulated or diversified away from these cycles entirely as titanium feedstock depends on titanium dioxide sales and both are at the mercy of paint sales. The combined company free cash flow for nine months is ($23.2) million with capex at $91.2 million.

They paid $31 million in dividends and spent $326 million repurchasing shares. Cash flow will not continue to support this level of shareholder returns and investment for the dividend and decreasing share count may be disappointing. The planned special dividend has already been cancelled.

Tronox bought shares at $26 even though by September they must have known an unprofitable, low margin Q3 with muted guidance would bring share prices down –- questionable motives and judgment. If the current downward cycling of TiO2 continues, share repurchases will be stopped and the dividend may be suspended.

Total debt is $1,638 million and there are covenants governing dividend payments and the issuing of new debt. The dividend will not be able to be paid from issuing new debt as it was this year. The debt to capital ratio is 37% and while not dangerously high, there is little headroom for increasing that under current economic conditions. For nine months the interest coverage ratio was 28X, but will decrease as the interest on the new notes is annualized.

Tronox had negative operating income for the third quarter and is predicting Q4 will be more of the same. A dividend that can be cut will not put much of a floor under the current price of $15 and ongoing negative earnings and eroding cash flow may continue to pressure share price. The dividend is now $1.00 per annum with a 6.6% yield. The special dividend will not be paid.

Aproximately 90% of the world’s consumption of titanium feedstock was used for TiO2 pigment, with the remainder being used for the production of titanium sponge for titanium metal manufacturing and other uses, such as the production of fluxes for welding rods and as a metallurgical flux in iron and steel making. Tronox revenue is 77% from TiO2.

The naturally occurring high-grade titanium minerals required for the production of TiO2 pigment are in limited supply. In response, the industry developed “beneficiated” products that can be used as substitutes for, or in conjunction with, naturally occurring titanium minerals. Two processes have been developed: one for the production of titanium slag and the other for the production of synthetic rutile. Both use ilmenite as a raw material. Exxaro gives Tronox a supply of both high-grade titanium and the means to make synthetic rutile.

Exarro had negative earnings in 2009 and had net profits of around $1 million in 2010. By 2011 they had recovered and earnings were approximately $287 million.

Margins in 2011:

40% operating margins39% operating margins (with a tax benefit)

When the macro-environment improves, the Exxaro acquisition should help expand margins —- a potential catalyst. Knowing when the cycle is going to turn is difficult. Without high demand for coating and paint, both the mining and TiO2 businesses will be slow.

CFFO in 2011 was $220.3 million compared to $95.9 million in 2010. They were cash flow negative in 2009.

Guidance

Tronox ix expecting market conditions for TiO2 pigment in Q4 to be similar to Q3. If that’s the case, they will have negative earnings (-0.14¢ in Q3) and may turn operating cash flow negative if the results are worse than Q3.

During the third quarter, average selling prices of TiO2 were approximately 6% lower than Q2. Given the softening of sales volumes in the pigment segment, they expect further price declines in the fourth quarter.

The company anticipate sales volumes of its mineral sands (excluding Zircon)will remain steady and prices will be higher in Q4 2012 compared to 2011. Ore contracts have been subject to low locked in pricing and those unfavorable contracts began to expire in June.

Valuation

Sherwin Williams and PPG both warn of slower paint/coating sales in the last quarter of 2012 to at least the first half of 2013. This is consistent with Tronox guidance. Asia/Pacific will be especially weak according to Sherwin Williams.

PPG and Sherwin Williams also discuss TiO2 inventory, pricing and decreasing its use in paint formulations in their recent conference calls. Conditions in 2012 going into 2013 will not be a repeat of 2011. End users are using up inventory and will be buyers again, but even with destocking ending, restocking may be slow until Q2 and Q3 2013 when painting season commences. There is mention of decreasing the TiO2 used in paint-- PPG says it plans to cut TiO2 consumption by 4%-6%. Both companies anticipate stabilization and possibly decreases in the price of TiO2.

Sherwin WilliamsRobert J. Wells - SVP, Corporate Communications and Public Affairs: What we mean by stability is that pricing is no longer – does not appear to be rising. We do not believe that the price increase announced by the industry affected in July was very successful. So, it appears that TiO2 pricing is stabilized.

Translation: TiO2 has no pricing power in the current environment and expect revenue and margins for Tronox to reflect that.

Robert J. Wells - SVP, Corporate Communications and Public AffairsJust as a reminder, Bob, the North American market consumes less than 25% of global supply of TiO2. So, we’ve got 75% – more than 75% of the global TiO2 market that’s struggling for volume even if North America is relatively strong.

Translation: International markets are weaker than North American markets and make up the biggest percentage of consumption. With the macro picture internationally and overseas even weaker than NA, expect global sales to suffer.

PPG Industries

Charles E. Bunch - Chairman and CEO TiO2 costs, as we look at them in the third quarter of 2012, were still up versus the third quarter of 2011, although the trend here in 2012 as we've moved through the year has been for lower prices for TiO2 in all the regions.

Translation: none needed—pricing power non-existent.

David Begleiter - Deutsche BankChuck, you discussed your efforts to reduce your usage of TiO2; I believe you had a 4% to 6% target for this year?

Charles E. Bunch - Chairman and CEO Yes and we are still on track through the first three quarters of this quarter we were tracking at a little over 3%. So we feel that for the full year we will be into certainly the 4% to 6% range, probably as we roll up all the numbers it will be kind of on the low end of that range or a little over 4%, but certainly within our target and we feel we still have opportunities as we go into 2013 and beyond to continue the more productive use of TiO2 in our formulation.

Translation: OMG! Dow was right—TiO2 can be reduced in paints and coatings and the new product formulation is comparable. The economics of changing the formulas are good enough to convince a major end-user (PPG) to start reformulating their paint. Evoque (the Dow polymer) can be used to reduce TiO2 content and still maintain hiding capacity. It can be used with the same concentration of TiO2 to create superior hiding ability.

Don Carson - Susquehanna Financial GroupSpeaking of inventory, we've seen about a $0.13 per pound price drop in TiO2, are you admitting it's a slow seasonal quarter for architectural paint, but are you drawing down your TiO2 inventories further in anticipation of more price reductions next, and then just clarification on your TiO2 reduction comment of 4% to 6%, is that total TiO2 or is that high quality chloride product an in part of what you are doing is substituting the low grade Chinese TiO2 into your formulation?

Charles E. Bunch - Chairman and CEOthat would be total TiO2. That's not substitution of sulfate or chloride, that's not in that calculation. And as I have mentioned in the earlier question, we still are going to hit at least the low end of that target which is a 4% productivity improvement in the usage for our overall TiO2, our formulation. And on the inventory destocking, we probably had a more inventory relative to sales early in the year, but as we've seen supply loosen up and pricing stabilized, we've worked down that inventory, so I would say now heading into this fourth quarter and into 2013, we have what I would call normal inventory levels for TiO2, so we're not trying to further destock from this level.

Translation: some important trends noted here. PPG is going to find ways to reduce TiO2 by 4%-6% and that does not include using the lower grade TiO2 from China. They don’t mention Evoque or Ropaque but that is probably what’s being put into their paint. They also mention destocking is winding down—Tronox has been saying the same thing. TiO2 pricing has come back to earth and end users will eventually be buyers again. I would not expect much purchasing in Q4 2012 or Q1 2013. They may start ramping up in anticipation of the busy painting season by Q2 2013. With better TiO2 prices for end users, there will be less hoarding and more normal supply and demand. However, demand will be seasonally down for a couple of quarters and long-term, could be a few percentage points lower if big companies start using Evoque in quantity.

Valuing Tronox is difficult with too little information and no data in the filings over numerous business cycles. There is not a long history available—it goes back to 2008. We can’t appreciate more than one cycle from the bottom in 2008 to the top in 2011. That history is peppered with adjustments and one-time charges/credits, an acquisition, and a change in year-end. There are also changes in the world of paint and coatings that are altering historical demand and we have no idea how much impact that will have. Then there is the seemingly endless gloomy macro-environment that cannot be completely quantified and whose end can’t be predicted.

What is the market pricing in now? TiO2 growth mirrors GDP. If we take the average GDP to be 3% then we get a rough framework to build a growth model on. China and Asia/Pacific often have higher growth than 3% and Europe/North America can be in negative numbers. In addition there is the looming threat of paint polymer additives that are going to decrease the use of TiO2 by some of the biggest paint manufacturers.

If we give the company 1% growth for 10 years and 0% terminal growth at an 11% discount, the value is $16. A catalyst considered by the model was the probable expansion of margins as the company sees better sales seasonally and the Exxaro acquisition increases margins as a source of lower cost feedstock. The mining operation itself has better margins and as it becomes a bigger percentage of annual revenue, will improve on the existing TiO2 margins.

Free cash flow is not predictable or consistent and the next 2-3 quarters are at risk for negative cash flow as sales continue to slow. The dividend will be at risk and the stock price may not have seen the bottom yet. There is no hurry to buy Tronox and waiting and watching for three to six months may help clarify what the combined companies are capable of during the trough of the cycle.

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